On 22nd July, the Tripartite Authorities (FSA, H.M. Treasury and the Bank of England) launched a detailed consultation on their proposals for a new Special Resolution Regime (SRR) for banks. The new legislation will introduce wide ranging and controversial new powers for the Tripartite Authorities to take control of banks and deal with their property and contracts before the formal point of insolvency is reached. The new legislation will also introduce two new insolvency procedures for banks: one specifically to deal with the management and winding up of the residue of a bank after one of the Authorities' tools in the SRR regime has been used and another new modified process which will be of general application to banks.
The new SRR legislation will impact a broad range of third party rights as well as banks and building societies.
The new legislation will be of concern not only to institutions within the scope of the new SRR but also to those who have property and other rights or interests which may be disturbed by the operation of the SRR. It threatens to undermine the legal certainty for counterparties dealing with UK banks and building societies.
The regime will apply to UK incorporated companies (including those owned by foreign groups) which are banks or otherwise have permission to accept deposits under FSMA and to building societies (but not credit unions) ('in-scope banks') and will extend to the overseas branches of such entities.
The operation of SRR will also impact third parties who have rights and obligations in relation to in-scope banks; these include shareholders and subordinated debt holders, account holders and other creditors, borrowers and counterparties (e.g. under financing arrangements and derivative contracts) and those with commercial contracts with the bank including suppliers such as IT providers.
Timetable – 15th September deadline
This is the third consultation document on the reforms to the banking system in the light of Northern Rock and the credit crunch and follows the broader consultation document on 'Financial stability and depositor protection: further consultation' published on 1st July. (If you would like to read our report on these issues, please click here). The consultations both close on 15th September with SRR legislation to be introduced shortly thereafter.
Banks and other interested parties need to respond to these very important changes and will have to address these issues over the holiday period. The BBA has played a key role in responding to the original SRR proposals in the first tripartite consultation document in January but institutions need to do their own analysis and preparations and CP responses.
Main features of the SRR
The SRR gives the Authorities new powers when an in-scope bank is in financial difficulties that were not available when they had to deal with the run on Northern Rock last year. These are –
- various powers described as 'pre-insolvency
stabilisation tools' ('PST')
– these include a new bank administration process;
and
- a new insolvency regime for banks.
The PSTs are intended to provide the Authorities with the means to avoid a Northern Rock style 'run' on a bank; in theory, the new powers would enable the Authorities to maintain the continuity of banking accounts for retail/protected depositors even if the bank eventually went into insolvent liquidation. It is proposed that the PSTs and the related systems which banks will be required to maintain in case PSTs are used, would enable the authorities to transfer retail deposit accounts so that depositors could access them within 7 days.
To achieve this objective, the PSTs give the authorities very wide ranging powers, and with considerable discretion, to deal with the bank and its assets/business and to interfere with related third party rights. These powers arise before a bank is formally insolvent, based on an assessment by the FSA of regulatory triggers.
The PSTs consist of the following:
- Private sector purchaser tool - to
facilitate a rescue by a sale of the bank to another
institution
- Bridge bank tool – to
facilitate a rescue by transferring the bank's
business to a new state controlled vehicle as a temporary
measure (pending agreement of a private sector
solution)
- Partial transfer tool – to
facilitate a rescue by splitting the bank and transferring
part of its assets and liabilities (e.g. the retail/protected
deposit and current accounts) using one of the PSTs above.
The residual assets/liabilities relating to the rest of the
bank's business would be left behind, so the original
bank entity becomes a 'rump' bank. This tool
includes a new special bank administration procedure to
maintain the rump bank to support the transfer and operation
of the protected accounts.
- Temporary public ownership tool
– to facilitate a rescue as was eventually
implemented for Northern Rock under special emergency
legislation which is due to expire.
The new legislation (some draft clauses of which have been published) has a regulatory style with stated objectives for the authorities when exercising their powers and a layered approach with secondary legislation and a third layer in the form of, what amounts to, a code of conduct for the Authorities when exercising powers under the SRR.
There are highly complex provisions to deal with the respective roles and veto rights as between the Tripartite Authorities themselves and the FSCS. Broadly speaking, the FSA will control the SRR trigger but the PSTs will be administered by the Bank of England. The Treasury will have various veto rights.
Key issues
The new legislation raises many complex and important issues both for in-scope banks and for third parties who deal with them.
Legal certainty undermined
- The SRR undermines the rights of counterparties
and threatens the legal certainty upon which many markets
(and related regulation) currently operate. It
threatens the standing of UK banks and building societies as
counterpaties and may therefore increase their costs. Netting
and security arrangements are potentially undermined by the
SRR. Legal opinions (which may be required for regulatory
and/or pricing purposes) on the effectiveness of early
termination rights and netting (which cover the effectiveness
of contractual protections both pre-insolvency and upon
insolvency of the counterparty bank) will have to be
qualified.
- It also undermines the rights of other stakeholders such
as shareholders.
- There are insufficient safeguards
- The balance has been wrongly struck between, on the one
hand, the permanent adverse impacts on all
UK banks and building societies and, on the other hand, the
SRR powers which the authorities may rarely use.
Creditors - the exercise of PSTs or the bank insolvency regime may adversely impact creditors (secured and unsecured), contractual counterparties (under derivative/financial and commercial contracts) and shareholders/subordinated debt holders of the bank.
Contractual protections for counterparties, such as prohibitions on assignment without prior written consent and termination and default clauses in contracts that would be triggered by SRR, are to be overridden and rendered ineffective.
Cherry–picking. The Authorities will be able to cherry pick what is transferred to a bridge bank and what remains in the rump bank.
- The Authorities believe that, as part of this cherry
picking, they will need to have the power to override
some security arrangements, master netting agreements and
structured finance arrangements. A key issue is
whether, and how, satisfactory protection from these powers
can be defined. For example, it is proposed that
master-netting agreements could not be overridden in relation
to 'qualifying financial contracts' (swaps,
futures, options, forwards and certain deposits are listed
but no mention is made of protecting debt obligations
generally). Whilst it appears to be accepted that SRR cannot
override collateral which is within the scope of, and
protected by, the Financial Collateral Arrangements
Directive, many security arrangements fall outside this
directive. In-scope banks and counterparties will need to
consider the wide variety of (existing and future) contracts
which are potentially impacted by these powers and whether
the proposed protections would be sufficient.
- The new special administration regime for the rump bank
may prejudice creditors and counterparties that have not been
transferred.
Compensation provisions are not an adequate safeguard. There are provisions dealing with compensation for shareholders of the bank on a transfer to a bridge bank; this is in the form of a bank resolution fund reflecting the economic benefit derived by the bridge bank. A more difficult issue is the impact on third parties and counterparties; the proposed arrangements for compensation in this context are very uncertain. Under the SRR objectives, the protection of rights under Human Rights legislation is not expressed to be paramount.
Effective priority for retail depositors? In addition to the concerns above, the new bank insolvency regime puts the payout of compensation to the retail depositor base as the primary objective, with achieving the best result for the bank's creditors as a whole, secondary.
There are still real doubts as to whether some aspects of the SRR would work in practice?
The experience with Northern Rock highlighted the many potential conflicts with EU law and the UK's international legal obligations. These have not been resolved within the legislation; there are merely powers, for example, for the Treasury to stop the Bank of England taking steps which would involve a breach of this kind.
It is still very unclear how SRR would work in the case of a UK bank which was part of an international group or operations. There will be provisions which will impact intra-group contracts but, whilst these will be of concern to banks, they are unlikely to resolve these difficulties for the authorities. No solution is provided for the transfer of contracts and assets which are subject to foreign law.
The practicalities of achieving an effective transfer of retail accounts within 7 days is not considered. There are real doubts as to whether this could be achieved in the way suggested and whether the difficulties can be overcome through the proposed systems requirements on in-scope banks. The burden of such systems may be disproportionate particularly if a bank is required to operate such systems on a single customer view basis across a number of different brands.
The provisions dealing with the division of responsibility between the different authorities and related veto rights suggest that the operation of the SRR, with the involvement of four authorities and with the potential for conflicts with the UK's international legal obligations, may be difficult.
The Exposure of FSCS levy payers is another concern – they will have to fund/contribute to the costs of SRR.
The industry will be liable to pay SRR costs. The policy justification is based on the possibility that SRR and the associated costs may be less expensive for levy payers and the industry, than current contributions under the FSCS if the bank went straight into insolvency. This logic may not stand up to scrutiny. Levy payers will have to pay for the cost of financial assistance required during the resolution period and may have to pay market value for state guarantees which are provided; they may also be liable for the cost of compensation payable to third parties for the losses arising from the authorities exercise of PSTs.
With the possibility of industry funded financing under SRR, FSA may feel under pressure to trigger SRR at an earlier stage. This will be one of various changes involving the FSCS which will increase substantially the exposure of levy payers.
Seminar on Banking reform on 3 September (12 days before the current consultation closes)
One year after the start of the credit crunch and the run on Northern Rock, the proposals for banking reform are now starting to fall into place. We are therefore holding a seminar on 3 September 2008, which will review the latest proposals from the Tripartite Authorities. This will assist those involved in making or contributing to consultation responses but will be of much broader interest.
Our seminar will put the various reforms in context and will cover:
- the new SRR for UK banks and building societies and the
key issues that it raises;
- the reforms to prudential and financial requirements for
banks;
- depositor protection, both via the FSCS scheme and
market-led solutions for larger deposits.
The implications for a wide range of parties include account holders, bank counterparties – both financial and commercial, and firms which are liable to levies to fund SRR and bank insolvency.
Our seminar will be relevant to legal, regulatory risk and business divisions of banks and building societies and to a wide range of interested parties in the financial and other sectors, such as bank account holders, bank counterparties (both financial and commercial) and those interested in providing insurance and other forms of deposit protection.
The seminar will take place at Mitre House, 160 Aldersgate Street, London EC1A 4DD. Seminar registration is from 8.30am with breakfast; the seminar itself runs from 9.00-10.30 and has 1.5 hours of CPD points. The seminar and the materials provided are free of charge.
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 26/08/2008.
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